Table of Contents
What is a stock buyback?
How stock buybacks work
How buybacks affect investors
Reasons for a buyback
Benefits of share buybacks for investors
Buybacks vs. dividends
Downsides and effects on the economy
Alternatives to buybacks
The bottom line
What Is a Stock Buyback and Why Do Companies Do Them?
What Is a Stock Buyback and Why Do Companies Do Them?
May 11, 2022
6 min read
The main concern for investors is not necessarily whether a stock buyback is good or bad but rather is the company generating a good return on its investment.
Suppose a company has some extra cash at the end of year. They consider their options for how to utilize it: They could invest in a new factory or warehouse, hoping that expansion will boost profits; they could send some of the extra cash to investors in the form of dividends; or they could buy back company stock.
A stock buyback, also known as a share repurchase, happens when a company uses available cash to buy back publicly traded shares. The acquired stock is re-absorbed by the company, reducing the number of shares outstanding.
Buybacks tend to be welcomed by investors, and share prices often rise after a company announces a buyback program. Repurchases reduce the number of shares outstanding, which means a smaller supply. If demand for the shares remains consistent, the stock often will rise.
Buybacks also tend to improve a company’s price-to-earnings (P/E) ratio, a key valuation measure for investors. The P/E is calculated by dividing annual earnings per share by the number of shares outstanding. With fewer shares outstanding, earnings are spread over a smaller base. The denominator in the ratio (the number of shares), is smaller, so the P/E is too. A lower P/E means the company’s shares are a better value. At the same time, existing shareholders will hold a bigger piece of the company pie as their ownership stake increases.
Stock buybacks are usually initiated by company management after they determine there are no other profitable uses for available cash. The company can purchase the stock on the open market or directly from its shareholders, but it takes board approval to set the process in motion.
Companies put out a press release and make a filing known as an 8-K with the Securities and Exchange Commission (SEC). Share repurchases are usually discretionary, and the company only buys when it deems the price to be acceptable. Once a share repurchase occurs, the company may hold the stock as treasury shares for future use or cancel them. Either way, the result is to reduce the number of shares outstanding, helping to benefit existing shareholders.
Companies that initiate stock buybacks generally do it in one of two ways:
When managers think the stock price is a good value, they may repurchase stock as they see fit or use a prescheduled approach to buybacks. Often with a buyback announcement, the share price increases because the market views it as a positive sign. The share repurchase is contingent on management’s belief that the shares are worth buying at current prices, and sometimes planned repurchases don’t take place.
This is called a tender offer. This occurs when a company offers to buy back shares within a certain time frame, usually for more than the price on the open market. Shareholders decide how many shares they wish to tender at a price they are willing to accept.
Here’s an example of what a share repurchase might look like for an investor.
Imagine a company that’s experiencing good growth and profitability, but it believes that its stock price doesn’t reflect the business’s true value. The company may decide to buy back shares at current market prices because it considers them undervalued.
For simplicity's sake, let’s say there are 100,000 shares outstanding. If the company were to buy back 20% of its shares using $200,000 of available cash, the number of outstanding shares would be reduced from 100,000 to 80,000.
Here is how the ownership stake of an investor with 1,000 shares would change based on simple math.
Pre-buyback: 1,000 shares divided by 100,000 = 1%. In other words, the investor owned 1% of the company’s shares.
: 1,000 shares divided by 80,000 = 1.2%. The investor now holds 1.2% of the company’s shares.
There are a variety of reasons companies buy back shares. Company management may consider a buyback to increase the stock’s market value. Even though the company may have generated earnings growth, management may believe the stock price doesn’t reflect the business’s fundamental value.
For other companies, lackluster earnings results, a negative news report, or an adverse economic climate may lead to share valuations that management believes are unjustified.
Dilution is another popular reason for a company to do a buyback. Stock dilution is often the result of shares issued through employee stock option plans (ESOP) or 401(k) programs. Either of these tend to increase the number of shares outstanding, diluting the value of other shareholders. These additional shares also affect important financial measures, lowering the earnings-per-share ratio (EPS)—a critical input in the P/E calculation.
A buyback tends to boost EPS and lower the P/E, creating more attractive share valuations.
For many investors, buybacks can be a plus; they see it as an effective way to reward shareholders. Because buybacks reduce the supply of shares available for public trading, while also improving key share valuation metrics, they tend to boost a stock’s price. Often, simply the announcement that a company plans to repurchase stock is enough to send share prices higher.
Buybacks also have none of the potential tax liabilities of dividend payments.
Both buybacks and dividends are similar in that they represent a use of corporate cash. But there are important differences:
Stock buybacks are often criticized by those who see them as gimmicks that do nothing for economic growth. Among their arguments they raise:
When it comes to increasing shareholder value, buying back stock represents only one way companies can use available cash. The following are other uses of capital:
By shrinking the number of shares outstanding, buybacks often lift stock valuations for shareholders in the short term. While the process improves financial ratios that can favor the company and the investor, it’s important to remember that the company used money that potentially could have been used in other ways.
The main concern for investors is not necessarily whether a stock buyback is good or bad but rather is the company generating a good return on their investment.
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